The effectiveness of R&D tax incentives

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1 The effectiveness of R&D tax incentives Pierre Mohnen Workshop on the revision of state aid rules for research and development and innovation (R&D&I)

Indirect government support through R&D tax incentives No data/cost estimate available RUS USA (2008) ISR (2008) FRA (2008) SWE KOR (2008) SVN CZE ESP (2007) ZAF (2008) AUT (2007) GBR NOR DEU (2008)

2 Indirect government support through R&D tax incentives No data/cost estimate available RUS USA (2008) ISR (2008) FRA (2008) SWE KOR (2008) SVN CZE ESP (2007) ZAF (2008) AUT (2007) GBR NOR DEU (2008) ISL (2008) BEL (2007) EST FIN CHN TUR IRL (2008) HUN (2008) NZL (2007) LUX DNK ITA (2008) CHE (2008) NLD AUS (2008) JPN (2008) PRT (2008) CAN POL SVK MEX (2007) GRC (2007) CHL (2008) BRA Direct government funding and R&D tax incentives in % of GDP Source: OECD, Main Science and technology Indicators, 2011

3 Market failures in R&D&I Spillovers Disincentive from imperfect appropriation Social return higher than the private return Asymmetric information Uncertainty and incomplete capital markets for risky events Large size and indivisibility of certain projects Coordination problems (e.g. skills availability)

4 Kinds of R&D tax incentives In proportion to the level of the expenses immediate write-off or expensing tax credits proportional to the level of R&D In proportion to the increment of R&D Definition of the base (fixed or variable, e.g. last two years) Measures intended to remove ceilings in the effective use of tax incentives refundability of unused tax credits Carry-back and carry forward of unused tax credits Flow through mechanisms, i.e. transfer of unused tax credits to an eligible third party Focus on specific types of R&D environment, health, defense, agriculture, information university, small and medium enterprises (SME), regional support, R&D cooperation Indirect tax incentives reduced corporate income taxes, exemption of capital gains taxes Reduced taxes on dividends from venture capital funding Reduced taxes for high-skilled immigrants

6 Price elasticity of R&D Netherlands: short-run -0.3, long-run -0.7 Quebec: Small firms: in SR, in LR Large firms: in SR, in LR Comparison with other studies: Bloom, Griffith, van Reenen (2002), -0.1 in SR, -1.0 in LR Harris, Li, Trainor (2009), in SR, in LR Wilson (2005), in LR -1.0 within states, but given market stealing from out-of-state, total effect -0.1 Mairesse-Mulkay, 0.6 after 2008, above 2 before 2008 (incremental R&D tax credit)

7 Not all firms apply for R&D tax credits Higher probability to apply if Capacity for innovation (human and financial capital) Stable financial position Received R&D subsidies before SMEs incur obstacles in applying for R&D tax credits Corchuelo and Martinez-Ros report that in Spain around 50% of the firms in 2002 did not know about the tax incentives and only 29% of those you knew used them.

8 Ways to assess effectiveness of R&D Additionality Cost-effectiveness ratio Incrementality ratio Tax sensitivity ratio Full Cost benefit analysis Spillovers Administration costs Compliance costs Opportunity costs General equilibrium analysis Wage effects Balanced budget Open trade Second-order effects Third-order effects

9 Bang for the buck (BFTB) Definition: changes in R&D/changes in tax expenditures Deadweight loss: Paying for R&D levels and R&D increases that would have happened anyway

10 0 mean BFTB Figure 1: Mean BFTB after t years Large and small firms Years Large firms All firms Small firms

11 BFTB in Quebec If level-based R&D tax credit increases by 10%, for small firms, the BFTB stays above 1 after 20 years, for large firms it falls below 1 Deadweight loss: 68% for small firms, 82% for large firms If increment-based R&D tax credit increases by 10%, the BFTB= 2.98 for small firms, 2.79 for large firms

12 Sensitivity analysis (from Parsons and Phillips, 2007)

13 Wage effects Why? To stimulate researchers to apply for R&D tax credits Supply constraint of R&D personnel Search costs for R&D personnel Negotiating power of R&D personnel Elasticity of the R&D wage with respect to the fraction of the wage supported by the fiscal incentives scheme is estimated at 0.1 in the short run and 0.13 in the long run.

14 Extensive margin Attract new R&D performers Because of sunk entry costs, give extra incentive to newcomers to cover these costs Because of R&D persistence, effects are long-lasting low deadweight loss 25% of manufacturing firms in Spain need subsidies to enter but not to continue R&D This would raise the percentage of R&D performing manufacturing firms in Spain from 20% to 30%, cost 110 million Euro but yield over 15 years 2,500 million Euro of additional R&D stock Study by Pere Arqué-Castells and Pierre Mohnen, Sunk costs, extensive R&D subsidies and permanent inducement effects, UNU-MERIT working paper

15 Increment-based R&D tax incentives Pros Less deadweight loss Larger bang for the buck Cons Little effect of the user cost of R&D More effective with fixed base than with rolling base, although fixed base not very realistic. Limit to R&D acceleration

16 Pros Pros and Cons of R&D tax incentives Let the private sector decide on the allocation of funds and let it foot part of the bill Neutral, not biased towards particular projects Predictable, reliable Lower administration costs than direct subsidies Cons R&D tax incentives are not terribly effective in stimulating more R&D than the amount of tax revenues foregone in the long run, except perhaps for small firms Deadweight loss for level-based R&D tax credits Tax incentives support more the big firms than the small firms even if rates are more favorable for small firms Tax incentives might lead to research projects with a low rate of return, unprofitable without the tax support Benefits partly washed out by a wage effect

17 Policy discussion Deadweight loss and effectiveness should be compared for tax credits versus direct government aid for R&D support. Combine R&D tax incentives with other incentives and complementary measures (e.g. creating human capital) Coordination of tax incentives to avoid tax competition Devise tax incentives or other means of support for innovation appropriate to the particular market failures (e.g. spillover, financing problems, or human capital insufficiencies) Keep tax laws stable

Fiscal Policies for Innovation and Growth

Fiscal Policies for Innovation and Growth Chapter 2 of the April 2016 Fiscal Monitor Peterson Institute March 31, 2016 1 Growth at the frontier United States Real GDP per Capita, 1929-2030 (2009 dollars,